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Assignments and restrictive covenants in Ontario: franchisors take note

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Franchisors concerned about how they may wish to handle an assignment of a franchise can look to two 2015 decisions of the Ontario Court of Appeal for guidance. In the first decision, 2147191 Ontario Inc. v. Springdale Pizza Depot Ltd.[1], the Ontario court reinforced the policy and purpose of the Arthur Wishart Act (Franchise Disclosure), 2000[2] (the Act). In the second, MEDIchair LP v. DME Medequip Inc. et al.[3], the court considered a restrictive covenant in a franchise agreement in the context of the current business of the franchisor and determined that it was unreasonable to enforce it.

THE SPRINGDALE PIZZA DEPOT LTD. DECISION

Determining a franchisor’s extent of involvement in an assignment

In Springdale, the assignee of a franchise commenced an action against the franchisor for a declaration that it was entitled to rescind its franchise agreement. The plaintiffs argued that since they had not received full disclosure from the franchisor, as required under the provisions of the Act, they had two years within which to seek rescission.

The franchisor presented two arguments in defence:

Since the assignee/franchisee purchased its franchise from an existing franchisee, pursuant to sections 5(7) and 5(8) of the Act, there was no need for any disclosure by the franchisor.

If the plaintiffs did have a right to disclosure, the documents provided to these plaintiffs were, at most, incomplete. Accordingly, if the plaintiffs were entitled to rescission, they did not have two years in which to seek that remedy.

Section 5(1) of the Act prescribes the disclosure requirements before a franchisee signs franchise documentation. Section 5(7) provides when disclosure is not required. One of these instances is when the grant of the franchise is not effected by or through a franchisor (e.g., the assignment of the franchise by one franchisee to another.) Section 5(8) goes on to describe this situation. It sets out that neither requiring the franchisor’s consent nor the payment of a transfer fee to the franchisor (which is not more than reasonable actual costs incurred) means that the grant was effected by or through a franchisor.

The franchisor’s franchise agreement did require the franchisor’s consent to the assignment and the payment of a fee. The lower court[4] determined that the franchisor was not required to make disclosure “unless they did something more than merely approving the transaction and receiving a fee.”[5] (Emphasis added)

That court found that the franchisor had definitely done more. The franchisor met on three separate occasions with the assignee prior to the assignee signing the assignment. There was some discussion of the assignee signing a new agreement, as opposed to an assignment. Most significantly, the franchisor required the assignee/franchisee to enter into an acknowledgement (which was not a requirement in the franchise agreement). The acknowledgement was to the effect that the assignee had not relied upon any representations of the franchisor regarding the sales figures of the business. The court decided that the franchisor “went beyond a mere passive role limited to the specific requirements required for its consent under the franchise agreement.”[6] This went beyond the fee and the consent to the transfer. This court also found that the acknowledgement limited the plaintiffs’ rights under the Act.

The court then determined that since the exemption provisions of the Act were not available and since there was not sufficient disclosure, the assignee was entitled to rescission.

The Court of Appeal

The Court of Appeal only had to address whether the judge had erred in determining that the exemption provisions were not applicable. This court determined that the lower court judge’s findings were justified on the facts, consistent with the spirit of the case law from the Court of Appeal in its interpretation of the Act, and recognized “both the overall purpose of the Act and the need to ‘narrowly construe’ the disclosure exceptions in the Act.”[7]

THE DME MEDEQUIP INC. DECISION

Franchisor’s restrictive covenant

MEDIChair LP is a franchisor with a network of franchisees that sell and lease home medical equipment. DME Medequip Inc. (DME) was a franchisee in the Peterborough area for 20 years. The principals of DME transferred the franchise to 2169252 Ontario Inc. (“2169252”) and its principals, with the approval of MEDIchair LP. The franchise agreement contained a restrictive covenant that prohibited the franchisee from operating a similar business within a 30-mile radius for a period of 18 months after termination.

Upon the expiry of the agreement in January 2015, DME removed the reference to MEDIchair from its signage, continued to operate its business at the same premises with the same product and staff and advised its suppliers that it would be carrying on business under a new name. MEDIchair LP sued to have its restrictive covenant enforced.

Initially, 2169252 argued that when it took an assignment of the franchise, MEDIchair LP did not comply with the provisions of the Act, as 2169252 was not provided with a copy of the agreement. 2169252 also argued that MEDIchair LP could not rely on the exemption provisions in the Act because MEDIchair LP had too much involvement in the transfer. In addition to non-compliance with the Act, the franchisee argued that the restrictive covenant was not valid and enforceable.

The lower court was of the view that the franchisor had very little involvement in the sale of the franchise and, accordingly, disclosure was not required. Nor did the lower court accept the arguments that the restrictive covenant was an unreasonable restraint on trade, freedom or competition or that the restrictive covenant was ambiguous. 2169252 also could not convince the Superior Court that MEDIchair LP did not have a legitimate business or proprietary interest to protect. The court looked at the similar covenant that 2169252 exacted from DME when 2169252 purchased the franchise. Finally, this court considered the evidence presented that the MEDIchair LP franchise system was in decline and that MEDIchair LP had no intention of opening a location in the Peterborough area, and determined that the integrity of the franchise system would be significantly compromised if “franchisees were simply allowed to walk away from the terms of the Agreement if MEDIchair was unable to establish that another store was going to open in the same area.”[8] As a result, the court determined that the restrictive covenant had been breached and it was enforceable.

The Court of Appeal

This court determined to only address the one issue: whether the franchisor was entitled to enforce the restrictive covenant when it had no intention of opening a location within the area protected by the covenant. It determined to look at this covenant based upon an overall assessment of the clause, the agreement and the surrounding circumstances. In so doing, the Court of Appeal decided to focus its inquiry on whether there was a legitimate interest of the franchisor entitled to the protection of the covenant. The Ontario Court of Appeal did not find that the restrictive covenant was generally unreasonable or unenforceable. But since the franchisor had made a decision not to operate a MEDIchair LP franchise in the area, the franchisor had no legitimate or proprietary interest to protect within the defined territorial scope of the covenant, and, therefore, the covenant was not reasonable in these circumstances.

Assignments in Ontario: what franchisors should keep in mind

The Ontario courts are continuing to recognize the purpose and policy goals of the Act. This is especially to avoid the perceived inequities of powers within the contractual relationship and to narrowly construe the exceptions set out therein. Franchisors need to bear this in mind when preparing their documentation. Franchisors also need to be mindful of the extent to which they participate in the assignment of their agreements: enough so as to protect the system and ensure that they will have a strong franchisee, but not too much, so that they may be perceived to be doing more than approving the transfer. If they participate more, then full disclosure is required.

In addition, the Court of Appeal in Ontario appears to be establishing a policy of not willing to enforce a covenant for the benefit of a franchise system when there is nothing to protect within the restricted territory. When seeking to enforce their restrictive covenants, franchisors will now have to look at the reasonableness of the covenant, not only when the franchise agreement was entered into, but when the franchisor is seeking to enforce the restriction. Franchisors will have to actively protect their territories if they want to be able to enforce their restrictive covenants and protect their system.

Find out more about the implications of these cases for your business by contacting the author.

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DLA Piper is a global law firm with lawyers located in more than 40 countries throughout the Americas, Europe, the Middle East, Africa and Asia Pacific, positioning us to help clients with their legal needs around the world.

DLA Piper is a global law firm with lawyers located in more than 40 countries throughout the Americas, Europe, the Middle East, Africa and Asia Pacific, positioning us to help clients with their legal needs around the world.